03-23-2008, 11:05 AM
FINANCIAL CRISIS- BEAR STEARNS-BERNANKE-KERVIEL-GAMBLERS FOLLY?
http://www.hizb.org.uk/hizb/resources/is...folly.html
The past few weeks have seen extreme drops in world stock markets, emergency action by central banks to prop up investor confidence, and over the past weekend the virtual collapse of Bear Stearns (the 5th largest US Investment bank). The US Federal Reserve took the unprecedented decision to lower US interest rates by .75% for the second time since January in addition to an emergency cut over the weekend of .25% in order to try and loosen up the deepening gloom of the credit crunch. FX rates continued to gyrate wildly led by the drop in the US dollar as the "carry trade" speculating on higher yielding currencies unwound, the fall out from the sub-prime debacle continued with the government announcing that the UK taxpayer could be liable for up to £55 billion (£2,000 per taxpayer) in guarantees the government has made to shore up Northern Rock. In January Societe Generale, France's second largest bank, announced Euro 5 billion in losses associated with a rogue trader (Jerome Kerviel) incident. One would be forgiven for questioning the current stability of global capital markets, and for good reason.
There are three main flaws in the capitalist liberal market system which have all contributed to the crisis in markets. Fiat currencies, Credit creation and the growth of Derivatives markets. Rather than pointing fingers at those who administered or watched over the latest crisis - Brown/Darling, Bernanke and Kerviel, root and branch reform of the markets would be required to re-establish confidence in a rapidly deteriorating situation.
Fiat Currencies
Ever since Nixon took the US off the gold standard in 1971 when the dollar was freely exchangeable for gold at the fixed rate of $35 per ounce the dollar and the other freely floating (not exchangeable for any tangible asset) currencies of the world, indeed all of them have consistently and rapidly depreciated versus Gold which has intrinsic value when compared to other tangible commodities. Perhaps the best example of the depreciation of fiat currencies is the fact that it now takes over $950 US to buy one ounce of gold, compared to $35 in 1971 when it became free floating. That all governments are using fiat currencies only heightens the problem.
With fiat currencies, control over the printing and circulation of the currency falls to central and main clearing banks. Whilst some countries have been more austere in controlling the creation of money (post war Germany prior to European monetary union maintained strict money supply/inflation limits) others led by the US have opened the floodgates. With US and UK money supply numbers increasing by 8 to 12% yearly, and little sign of it lessening, the impact on inflation is tangible. With the Federal Reserve now making available a $200 billion facility to banks in crisis similar to Bear Stearns, the inflationary pressure and standing of the US dollar declines further. An emergency offer of 5 billion pounds to UK banks was eagerly oversubscribed this week 5 times over. That Bear Stearns was declared technically bankrupt and sold to JP Morgan for a nominal amount together with Federal Reserve guarantees of over $30 billion, only further highlighted the air of despondency and gloom.
Credit Creation and the Credit Crunch
But central governments are not the only institutions creating money out of thin air. The fragility of the financial markets is systematic, since it occurs when firms take on more and more risky ventures; and no amount of regulation can stop that fragility. This is why markets crash regularly, and every boom is followed by a crash or a downturn.
Greed is enshrined within the system. Greed is the motivation that led to predatory mortgage brokers selling mortgages to people that have no way in paying it back, and then increasing the rates of interest until the buyer defaults. Greed is also the motivation that led the credit ratings agencies to rate the investments as much less risky than they were, and also to conceal that the risk was based on prime mortgage debt. Hedge funds demonstrate greed in the way they seek to provide astonishing returns to the customers, and greed is the motivation even for individual shareholders that want to capitalise on the falling share prices across the economy, even though it can lead to problems for thousands of people.
The effect of this is devastating; since each element within the system puts their benefit before ethics, morals and the impact on the wider economy, this is why we have a situation where even though the effect of investment decisions can lead to a downturn in the economy, companies are prepared to make those decisions anyway. The biggest problem here is that this motivation is seen as a virtue. Greed is good; so we are told, and hence we can see that this is a systematic problem; i.e. it is enshrined in the financial system.
Bear Stearns fell due to massive holdings of credit derivatives, particularly collateralised debt obligations - highly leveraged loan structures. With the real estate bubble bursting this market has dramatically fallen away, and those companies most highly leveraged are now paying the price. But the price is also being paid by taxpayers and the common man in the street who shares in the government bailouts which the central banks are so happy to put up - everyone suffers as the currency is diluted by these bailouts, and taxpayers ultimately must balance the budget, if not with this government then in the time of future generations.
The Growth of Derivatives
The world economy equates to $50 trillion of gross domestic product, whereas derivatives, generally created from within the banking system, now is over $500 trillion. Financing exceeds economic output by at least a factor of 10 - and for what purpose?
The financial system serves an economic function of its own: Additional finance is needed to grow the real economy (loans, investment in business or foreign exchange). But credit has expanded far faster than production. This has impaired the ability of those living in the real economy to service debt. The banks produced trillions of dollars of derivative instruments and sold them to hedge funds. Hedge funds produced more and sold them back to banks. Generally little capital backed these promises. So when it fails it fails spectacularly.
George Soros once appeared before the House Banking Committee and stated: "There are so many (derivatives), and some of them are so esoteric that the risks involved may not be properly understood even by the most sophisticated of investors, and I'm supposed to be one of them." After Congress completed its study, then Federal Reserve chairman Alan Greenspan dismissed it as unnecessary. He described the risk of derivatives as "negligible." Congress chose to believe the testimony of Greenspan and ignore Soros.
In May of 2003 Greenspan said: "Derivatives have permitted financial risks to be unbundled in ways that have facilitated both their measurement and their management... As a result, not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient."
The writer Henry Kaufman viewed the development differently: "Institutions with aggressive (derivative) models will get the business and garner the profits. Senior managers will find it more difficult to resist increasing pressures to compete using riskier models, especially if doing so would cause the earnings and stock process to lag behind those of institutions deploying riskier models. Ongoing financial intermediation and balance sheet leveraging also will continue to support riskier modeling on the near horizon."
One should not be surprised that Jerome Kerviel of Societe Generale "bet the firm" on the direction of the stock market to the tune of several billion Euros earlier this year, he was merely attempting to maximise profits and hence his bonus. If everyone else is doing it the pressure is on - merely to keep up. In March of last year, before the current round of crises, Kaufman viewed the preferable solution as impractical.
"One [solution] is to let competitive forces discipline market participants," Kaufman said. "In this scenario, the managers who perform well will prosper, while those who do not will fail. [But] the failure of behemoth financial conglomerates not only exacts enormous social costs, but also poses systemic risks for markets around the world."
But the market is trembling and to shore up any remaining confidence has required massive intervention.
Conclusion
An independent thinker would be entitled to ask where is the free market? Surely, if banks are going to involve themselves in such risky instruments they should carry the consequences.
The argument the custodians of the system bring is that "certain" banks are too big to fail, the risk of systemic counterparty meltdown is just too great, hence the need for bailouts. Yet, the public is not party to the approval of bailing out these large "gambling" houses and is funding them during tough times, yet does not benefit from the massive bonuses paid in the good years.
As long as the laws are so lax to allow unrestrained credit creation, derivatives which are not based in the real economy, and fiat currencies, we will all suffer from these contradictory policies (all matters forbidden in Islam). The so called "free market" is not looking so free anymore.
BEARLY ALIVE:INVESTMENT GIANT RUSHED TO ICU
Mike Whitney
http://www.informationclearinghouse.info...e19541.htm
On Friday, Bear Stearns blew up. It was the worst possible news at the worst possible time. A day earlier, the politically-connected Carlyle Capital hedge fund defaulted on $16.6 billion of its debt. Carlyle boasted a $21.7 billion portfolio of AAA-rated residential mortgage-backed securities, but was unable to make a margin call of just $400 million. (Where did the $21.7 billion go?) The news on Bear was the last straw. The stock market started reeling immediately; shedding 300 points in less than an hour. Then, miraculously, the tide shifted and the market began to rebound. If there was ever a time for Paulson's Plunge Protection Team to come to the rescue; this was it. For weeks, the markets have been battered with bad news. Retail sales are down, unemployment is up, consumer confidence is in the tank, inflation is rising, the dollar is on the ropes, and the credit crunch has spread to even the safest corners of the market. Facing fierce headwinds, Washington mandarins and financial heavyweights had to decide whether to sit back and let one small investment bank take down the whole equities market in an afternoon or stealthily buy a few futures and live to fight another day? Tough choice, eh?
We'll never know for sure, but that's probably what happened.
We'll also never know if Bernanke's real purpose in setting up his new $200 billion auction facility was to provide the cash-strapped banks with a place where they could off-load the mortgage-backed junk that Carlyle dumped on the market when they went belly-up. That worked out well, didn't it? Now the banks can trade these worthless MBS bonds with the Fed for US Treasuries at nearly full value. What a deal! That must have been the plan from the get-go.
The Bear Stearns bailout has ignited a firestorm of controversy about moral hazard and whether the Fed should be in the business of spreading its largess to profligate investment banks. But the Fed had no choice. This isn't about one bank caving in from its bad bets. The entire financial system is teetering and a failure at Bear would have taken a wrecking ball to the equities market and sent stocks around the world into a violent death-spiral. The New York Times summed it up like this in Saturday's edition:
“If the Fed hadn't acted this morning and Bear did default on its obligations, then that could have triggered a widespread panic and potentially a collapse of the financial system”.
Bingo.
So, what makes Bear so special? How is it that one of the smallest investment banks can pose such a threat to the whole system?
That's the question that will be addressed in the next couple weeks and people are not going to like the answer. For the last decade or so the markets have been reconfigured according to a new “structured finance” model which has transformed the interactions between institutions and investors. The focus has been on maximizing profit by creating a vast galaxy of exotic debt-instruments which increase overall risk and volatility in slumping market conditions. Derivatives trading which, according to the Bank of International Settlements, now exceeds $500 trillion, has sewn together the various lending and investment institutions in a way that one failure can set the derivatives dominoes in motion and bring down the entire financial scaffolding in a heap. That's why the Fed got involved and (I believe) approached Congress in a closed-door session (which was supposed to be about FISA legislation) to inform lawmakers about the growing possibly of a major economic meltdown if conditions in the credit markets were not stabilized quickly.
The troubles at Bear and the danger they pose to the overall system were articulated in an article by Counterpunch editor, Alexander Cockburn in a November, 2006 article “Lame Duck: The Downside of Capitalism”:
“In a briefing paper under the chaste title, 'Private Equity: A discussion of Risk and Regulatory Engagement', the FSA raises the alarm.
"Excessive leverage: The amount of credit that lenders are willing to extend on private equity transactions has risen substantially. This lending may not, in some circumstances, be entirely prudent. Given current leverage levels and recent developments in the economic/credit cycle, the default of a large private equity backed company or a cluster of smaller private equity backed companies seems inevitable. This has negative implications for lenders, purchasers of the debt, orderly markets and conceivably, in extreme circumstances, financial stability and elements of the UK economy."
Translation: It's about to blow!
"The duration and potential impact of any credit event may be exacerbated by operational issues which make it difficult to identify who ultimately owns the economic risk associated with a leveraged buy out and how these owners will react in a crisis. These operational issues arise out of the extensive use of opaque, complex and time consuming risk transfer practices such as assignment and sub-participation, together with the increased use of credit derivatives. These credit derivatives may not be confirmed in a timely manner and the amount traded may substantially exceed the amount of the underlying assets."(snip)
Translation: "The world's credit system is a vast recycling bin of untraceable transactions of wildly inflated value.
The problem is that the oversight and stability of the world credit system is no longer within the purview of familiar international institutions like the International Monetary Fund or the Bank of International Settlements. Private traders are now installed at all the strategic nodes, gambling with stratospheric sums in such speculative pyramids as the credit derivative market which was almost nonexistent in 2001, yet which reached $17.3 trillion by the end of 2005. Warren Buffett, America's most famous investor, has called credit derivatives "financial weapons of mass destruction." ( Alexander Cockburn, “Lame Duck: The Downside of Capitalism” )
Cockburn's article anticipates the current problems at Bear and shows why the Fed cannot allow them to fester and spread throughout the system. The investment banks and brokerages all do business with each other, taking sides in trades as counterparties. If one player goes down it increases the likelihood of more failures. So the problem has to be contained.
The volume of derivatives contracts, that are not traded publicly on any of the major exchanges, has exploded in the last few years. These unregulated transactions, what Pimco's Bill Gross calls the shadow banking system, have taken center-stage as market conditions continue to deteriorate and the downward-cycle of deleveraging begins to accelerate. The ongoing massacre in real estate has left the structured investment market frozen, which means that the foundation blocks (ie mortgage-backed securities) upon which all this excessive leveraging rests; is starting to crumble. It's a real mess.
Derivatives trading, particularly in credit default swaps, is oftentimes exceeds the value of the underlying asset many times over. Credit Default Swaps are financial instruments that are based on loans and bonds that speculate on a company's ability to repay debt. (a type of unregulated insurance) The CDS market is roughly $45 trillion, whereas, the aggregate value of the US mortgage market is only $11 trillion; four times smaller. That's a lot of leverage and it can have a snowball effect when the CDSs trades begin to unwind.
In truth, the biggest risk to the financial system is counterparty risk; the possibility that some large investment bank, like Bear, goes under and sucks the rest of the market with it from the magnitude of its losses. Last year, Bear was the 12th largest counterparty to CDS trades according to Fitch ratings. If they were to suddenly disappear, the effects to the rest of the system would be catastrophic.
Fed Chairman Bernanke sat on the board of the FOMC when the investment gurus and brokerage sharpies customized the markets in a way that enhanced their own personal fortunes while increasing the risks of systemic failure. The SIVs, the conduits, the opaque derivatives, the off-balance sheets operations, the dark pools, the massive leverage, and the reckless expansion of credit; all emerged during his (and Greenspan's) tenure. The Federal Reserve is largely responsible for the brushfire they are presently trying to put out.
Now, once again, Bernanke is acting beyond his mandate and invoking a law that hasn't been used since the 1960s so the Fed can become the creditor for an institution that attempted to enrich itself through wild speculative bets on dubious toxic investments which are now utterly worthless. If that isn't a good enough reason for abolishing the Federal Reserve; then what is?
The world's most transparent and profitable markets have been transformed into a carnival sideshow managed by hucksters, flim-flam men, and rip off artists. The Bear bailout is yet another glaring example of a system that lacks all credibility and is quickly self-destructing.
http://www.hizb.org.uk/hizb/resources/is...folly.html
The past few weeks have seen extreme drops in world stock markets, emergency action by central banks to prop up investor confidence, and over the past weekend the virtual collapse of Bear Stearns (the 5th largest US Investment bank). The US Federal Reserve took the unprecedented decision to lower US interest rates by .75% for the second time since January in addition to an emergency cut over the weekend of .25% in order to try and loosen up the deepening gloom of the credit crunch. FX rates continued to gyrate wildly led by the drop in the US dollar as the "carry trade" speculating on higher yielding currencies unwound, the fall out from the sub-prime debacle continued with the government announcing that the UK taxpayer could be liable for up to £55 billion (£2,000 per taxpayer) in guarantees the government has made to shore up Northern Rock. In January Societe Generale, France's second largest bank, announced Euro 5 billion in losses associated with a rogue trader (Jerome Kerviel) incident. One would be forgiven for questioning the current stability of global capital markets, and for good reason.
There are three main flaws in the capitalist liberal market system which have all contributed to the crisis in markets. Fiat currencies, Credit creation and the growth of Derivatives markets. Rather than pointing fingers at those who administered or watched over the latest crisis - Brown/Darling, Bernanke and Kerviel, root and branch reform of the markets would be required to re-establish confidence in a rapidly deteriorating situation.
Fiat Currencies
Ever since Nixon took the US off the gold standard in 1971 when the dollar was freely exchangeable for gold at the fixed rate of $35 per ounce the dollar and the other freely floating (not exchangeable for any tangible asset) currencies of the world, indeed all of them have consistently and rapidly depreciated versus Gold which has intrinsic value when compared to other tangible commodities. Perhaps the best example of the depreciation of fiat currencies is the fact that it now takes over $950 US to buy one ounce of gold, compared to $35 in 1971 when it became free floating. That all governments are using fiat currencies only heightens the problem.
With fiat currencies, control over the printing and circulation of the currency falls to central and main clearing banks. Whilst some countries have been more austere in controlling the creation of money (post war Germany prior to European monetary union maintained strict money supply/inflation limits) others led by the US have opened the floodgates. With US and UK money supply numbers increasing by 8 to 12% yearly, and little sign of it lessening, the impact on inflation is tangible. With the Federal Reserve now making available a $200 billion facility to banks in crisis similar to Bear Stearns, the inflationary pressure and standing of the US dollar declines further. An emergency offer of 5 billion pounds to UK banks was eagerly oversubscribed this week 5 times over. That Bear Stearns was declared technically bankrupt and sold to JP Morgan for a nominal amount together with Federal Reserve guarantees of over $30 billion, only further highlighted the air of despondency and gloom.
Credit Creation and the Credit Crunch
But central governments are not the only institutions creating money out of thin air. The fragility of the financial markets is systematic, since it occurs when firms take on more and more risky ventures; and no amount of regulation can stop that fragility. This is why markets crash regularly, and every boom is followed by a crash or a downturn.
Greed is enshrined within the system. Greed is the motivation that led to predatory mortgage brokers selling mortgages to people that have no way in paying it back, and then increasing the rates of interest until the buyer defaults. Greed is also the motivation that led the credit ratings agencies to rate the investments as much less risky than they were, and also to conceal that the risk was based on prime mortgage debt. Hedge funds demonstrate greed in the way they seek to provide astonishing returns to the customers, and greed is the motivation even for individual shareholders that want to capitalise on the falling share prices across the economy, even though it can lead to problems for thousands of people.
The effect of this is devastating; since each element within the system puts their benefit before ethics, morals and the impact on the wider economy, this is why we have a situation where even though the effect of investment decisions can lead to a downturn in the economy, companies are prepared to make those decisions anyway. The biggest problem here is that this motivation is seen as a virtue. Greed is good; so we are told, and hence we can see that this is a systematic problem; i.e. it is enshrined in the financial system.
Bear Stearns fell due to massive holdings of credit derivatives, particularly collateralised debt obligations - highly leveraged loan structures. With the real estate bubble bursting this market has dramatically fallen away, and those companies most highly leveraged are now paying the price. But the price is also being paid by taxpayers and the common man in the street who shares in the government bailouts which the central banks are so happy to put up - everyone suffers as the currency is diluted by these bailouts, and taxpayers ultimately must balance the budget, if not with this government then in the time of future generations.
The Growth of Derivatives
The world economy equates to $50 trillion of gross domestic product, whereas derivatives, generally created from within the banking system, now is over $500 trillion. Financing exceeds economic output by at least a factor of 10 - and for what purpose?
The financial system serves an economic function of its own: Additional finance is needed to grow the real economy (loans, investment in business or foreign exchange). But credit has expanded far faster than production. This has impaired the ability of those living in the real economy to service debt. The banks produced trillions of dollars of derivative instruments and sold them to hedge funds. Hedge funds produced more and sold them back to banks. Generally little capital backed these promises. So when it fails it fails spectacularly.
George Soros once appeared before the House Banking Committee and stated: "There are so many (derivatives), and some of them are so esoteric that the risks involved may not be properly understood even by the most sophisticated of investors, and I'm supposed to be one of them." After Congress completed its study, then Federal Reserve chairman Alan Greenspan dismissed it as unnecessary. He described the risk of derivatives as "negligible." Congress chose to believe the testimony of Greenspan and ignore Soros.
In May of 2003 Greenspan said: "Derivatives have permitted financial risks to be unbundled in ways that have facilitated both their measurement and their management... As a result, not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient."
The writer Henry Kaufman viewed the development differently: "Institutions with aggressive (derivative) models will get the business and garner the profits. Senior managers will find it more difficult to resist increasing pressures to compete using riskier models, especially if doing so would cause the earnings and stock process to lag behind those of institutions deploying riskier models. Ongoing financial intermediation and balance sheet leveraging also will continue to support riskier modeling on the near horizon."
One should not be surprised that Jerome Kerviel of Societe Generale "bet the firm" on the direction of the stock market to the tune of several billion Euros earlier this year, he was merely attempting to maximise profits and hence his bonus. If everyone else is doing it the pressure is on - merely to keep up. In March of last year, before the current round of crises, Kaufman viewed the preferable solution as impractical.
"One [solution] is to let competitive forces discipline market participants," Kaufman said. "In this scenario, the managers who perform well will prosper, while those who do not will fail. [But] the failure of behemoth financial conglomerates not only exacts enormous social costs, but also poses systemic risks for markets around the world."
But the market is trembling and to shore up any remaining confidence has required massive intervention.
Conclusion
An independent thinker would be entitled to ask where is the free market? Surely, if banks are going to involve themselves in such risky instruments they should carry the consequences.
The argument the custodians of the system bring is that "certain" banks are too big to fail, the risk of systemic counterparty meltdown is just too great, hence the need for bailouts. Yet, the public is not party to the approval of bailing out these large "gambling" houses and is funding them during tough times, yet does not benefit from the massive bonuses paid in the good years.
As long as the laws are so lax to allow unrestrained credit creation, derivatives which are not based in the real economy, and fiat currencies, we will all suffer from these contradictory policies (all matters forbidden in Islam). The so called "free market" is not looking so free anymore.
BEARLY ALIVE:INVESTMENT GIANT RUSHED TO ICU
Mike Whitney
http://www.informationclearinghouse.info...e19541.htm
On Friday, Bear Stearns blew up. It was the worst possible news at the worst possible time. A day earlier, the politically-connected Carlyle Capital hedge fund defaulted on $16.6 billion of its debt. Carlyle boasted a $21.7 billion portfolio of AAA-rated residential mortgage-backed securities, but was unable to make a margin call of just $400 million. (Where did the $21.7 billion go?) The news on Bear was the last straw. The stock market started reeling immediately; shedding 300 points in less than an hour. Then, miraculously, the tide shifted and the market began to rebound. If there was ever a time for Paulson's Plunge Protection Team to come to the rescue; this was it. For weeks, the markets have been battered with bad news. Retail sales are down, unemployment is up, consumer confidence is in the tank, inflation is rising, the dollar is on the ropes, and the credit crunch has spread to even the safest corners of the market. Facing fierce headwinds, Washington mandarins and financial heavyweights had to decide whether to sit back and let one small investment bank take down the whole equities market in an afternoon or stealthily buy a few futures and live to fight another day? Tough choice, eh?
We'll never know for sure, but that's probably what happened.
We'll also never know if Bernanke's real purpose in setting up his new $200 billion auction facility was to provide the cash-strapped banks with a place where they could off-load the mortgage-backed junk that Carlyle dumped on the market when they went belly-up. That worked out well, didn't it? Now the banks can trade these worthless MBS bonds with the Fed for US Treasuries at nearly full value. What a deal! That must have been the plan from the get-go.
The Bear Stearns bailout has ignited a firestorm of controversy about moral hazard and whether the Fed should be in the business of spreading its largess to profligate investment banks. But the Fed had no choice. This isn't about one bank caving in from its bad bets. The entire financial system is teetering and a failure at Bear would have taken a wrecking ball to the equities market and sent stocks around the world into a violent death-spiral. The New York Times summed it up like this in Saturday's edition:
“If the Fed hadn't acted this morning and Bear did default on its obligations, then that could have triggered a widespread panic and potentially a collapse of the financial system”.
Bingo.
So, what makes Bear so special? How is it that one of the smallest investment banks can pose such a threat to the whole system?
That's the question that will be addressed in the next couple weeks and people are not going to like the answer. For the last decade or so the markets have been reconfigured according to a new “structured finance” model which has transformed the interactions between institutions and investors. The focus has been on maximizing profit by creating a vast galaxy of exotic debt-instruments which increase overall risk and volatility in slumping market conditions. Derivatives trading which, according to the Bank of International Settlements, now exceeds $500 trillion, has sewn together the various lending and investment institutions in a way that one failure can set the derivatives dominoes in motion and bring down the entire financial scaffolding in a heap. That's why the Fed got involved and (I believe) approached Congress in a closed-door session (which was supposed to be about FISA legislation) to inform lawmakers about the growing possibly of a major economic meltdown if conditions in the credit markets were not stabilized quickly.
The troubles at Bear and the danger they pose to the overall system were articulated in an article by Counterpunch editor, Alexander Cockburn in a November, 2006 article “Lame Duck: The Downside of Capitalism”:
“In a briefing paper under the chaste title, 'Private Equity: A discussion of Risk and Regulatory Engagement', the FSA raises the alarm.
"Excessive leverage: The amount of credit that lenders are willing to extend on private equity transactions has risen substantially. This lending may not, in some circumstances, be entirely prudent. Given current leverage levels and recent developments in the economic/credit cycle, the default of a large private equity backed company or a cluster of smaller private equity backed companies seems inevitable. This has negative implications for lenders, purchasers of the debt, orderly markets and conceivably, in extreme circumstances, financial stability and elements of the UK economy."
Translation: It's about to blow!
"The duration and potential impact of any credit event may be exacerbated by operational issues which make it difficult to identify who ultimately owns the economic risk associated with a leveraged buy out and how these owners will react in a crisis. These operational issues arise out of the extensive use of opaque, complex and time consuming risk transfer practices such as assignment and sub-participation, together with the increased use of credit derivatives. These credit derivatives may not be confirmed in a timely manner and the amount traded may substantially exceed the amount of the underlying assets."(snip)
Translation: "The world's credit system is a vast recycling bin of untraceable transactions of wildly inflated value.
The problem is that the oversight and stability of the world credit system is no longer within the purview of familiar international institutions like the International Monetary Fund or the Bank of International Settlements. Private traders are now installed at all the strategic nodes, gambling with stratospheric sums in such speculative pyramids as the credit derivative market which was almost nonexistent in 2001, yet which reached $17.3 trillion by the end of 2005. Warren Buffett, America's most famous investor, has called credit derivatives "financial weapons of mass destruction." ( Alexander Cockburn, “Lame Duck: The Downside of Capitalism” )
Cockburn's article anticipates the current problems at Bear and shows why the Fed cannot allow them to fester and spread throughout the system. The investment banks and brokerages all do business with each other, taking sides in trades as counterparties. If one player goes down it increases the likelihood of more failures. So the problem has to be contained.
The volume of derivatives contracts, that are not traded publicly on any of the major exchanges, has exploded in the last few years. These unregulated transactions, what Pimco's Bill Gross calls the shadow banking system, have taken center-stage as market conditions continue to deteriorate and the downward-cycle of deleveraging begins to accelerate. The ongoing massacre in real estate has left the structured investment market frozen, which means that the foundation blocks (ie mortgage-backed securities) upon which all this excessive leveraging rests; is starting to crumble. It's a real mess.
Derivatives trading, particularly in credit default swaps, is oftentimes exceeds the value of the underlying asset many times over. Credit Default Swaps are financial instruments that are based on loans and bonds that speculate on a company's ability to repay debt. (a type of unregulated insurance) The CDS market is roughly $45 trillion, whereas, the aggregate value of the US mortgage market is only $11 trillion; four times smaller. That's a lot of leverage and it can have a snowball effect when the CDSs trades begin to unwind.
In truth, the biggest risk to the financial system is counterparty risk; the possibility that some large investment bank, like Bear, goes under and sucks the rest of the market with it from the magnitude of its losses. Last year, Bear was the 12th largest counterparty to CDS trades according to Fitch ratings. If they were to suddenly disappear, the effects to the rest of the system would be catastrophic.
Fed Chairman Bernanke sat on the board of the FOMC when the investment gurus and brokerage sharpies customized the markets in a way that enhanced their own personal fortunes while increasing the risks of systemic failure. The SIVs, the conduits, the opaque derivatives, the off-balance sheets operations, the dark pools, the massive leverage, and the reckless expansion of credit; all emerged during his (and Greenspan's) tenure. The Federal Reserve is largely responsible for the brushfire they are presently trying to put out.
Now, once again, Bernanke is acting beyond his mandate and invoking a law that hasn't been used since the 1960s so the Fed can become the creditor for an institution that attempted to enrich itself through wild speculative bets on dubious toxic investments which are now utterly worthless. If that isn't a good enough reason for abolishing the Federal Reserve; then what is?
The world's most transparent and profitable markets have been transformed into a carnival sideshow managed by hucksters, flim-flam men, and rip off artists. The Bear bailout is yet another glaring example of a system that lacks all credibility and is quickly self-destructing.